If you had been brave enough to buy Premier Oil(LSE: PMO) at the beginning of 2016, when the shares plunged to an all-time low of 19p, today you would be sitting on gains of just under 600%!
This performance is due to a combination of factors. The price of oil, which fell to a low of just under $30 a barrel in 2016, has charged higher and now changes hands for $74 and change. Meanwhile, Premier itself has taken action to improve profitability by slashing costs and putting major development projects on hold. And I believe this is just the start of Premier's turnaround.
Cash is king
I've written many times before that the most significant headwind facing Premier's shares is the company's debt. The firm has essentially staked its future on the success of its flagship Catcher development in the North Sea, which has cost billions to develop.
Until last year, Catcher was nothing but a drain on profitability, but now, production is ramping up. Output across the group averaged 76,100 barrels of oil equivalent per day (boepd) in the first half of 2018, and recently exceeded 90,000 boepd. For the full-year, management is guiding for 80,000-85,000 boepd.
Rising production, coupled with that $74 a barrel price tag, oil is allowing Premier to rapidly de-lever its balance sheet. The bulk of the group's oil production for the second half of the year is hedged at $60/bbl, below the current market price but fixed to give clarity on earnings. At this level, management believes net debt will fall by $300m-$400m for the year, taking a significant chunk out of the $2.72bn net debt balance reported at the end of 2017. The group's leverage ratio -- the ratio creditors rely on to judge whether Premier can meet its obligations -- is forecast to fall to 3x EBITDA by year end 2018 and 2.5x EBITDA by the end of March 2019. At the end of 2016, the ratio had ballooned to 5.9x.
With leverage now nearly halved since 2016, in my opinion the shares look desperately undervalued. In the past, the stock deserved a low multiple because of the bankruptcy risk surrounding the business. Now this risk has receded, but the stock still trades at a depressed valuation, giving a wide margin of safety for investors, in my view.
City analysts believe the company is on track to report earnings per share of $0.32 for 2019, or 24p based on current exchange rates (based on the current production rate this looks probable). This means the shares trade at a 2019 P/E of just 5.4, compared to the broader oil & gas sector average of 11.4. As Premier continues to clean up its balance sheet, I see no reason why the stock cannot trade up to this multiple -- as long as the price of oil doesn't collapse again.
Put simply, as Premier's borrowings continue to fall over the next 18-24 months, I believe the shares could be worth between 250p and 300p. There's still time to profit from the Premier recovery.
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Rupert Hargreaves owns no share mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.